Diversify your fixed income.
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Bond funds are an efficient way to add an important fixed-income counterweight to the equities part of a diversified investment portfolio. Unlike holding single bonds, bond funds offer a low-cost and easy way to diversify because they hold many securities.
Before you jump into a fund, take time to understand the mechanics of bonds and how those mechanics translate into bond funds. Also, make sure you understand bond mutual funds and bond exchange-traded funds (ETFs). Both are convenient ways to get exposure to fixed income, but there are clear differences between mutual funds and ETFs.
Key Points
- Bond funds make it easier to build a diversified fixed-income portfolio to mitigate the potential impact of an individual bond default.
- Bond funds are run by professional managers who can buy bonds in hard-to-access parts of the debt market much more easily and cheaply than an individual investor.
- Bond mutual fundsâa common offering in 401(k) plansâsettle and trade once per day, whereas bond ETFs trade throughout the day, like stocks.
A bond fundâalso called a fixed-income fund because bonds are a type of fixed-income securityâholds many types of bonds in one investment vehicle. There are index bond funds, such as one that follows the Bloomberg U.S. Aggregate Bond Index, and actively managed bond funds, where the portfolio manager selects the holdings and decides when to buy or sell.
When you look under the hood of a given fund, its holdings will define the type of fund it is. As you do your research, pay attention to these key criteria.
- Maturity: The average age of the bonds the fund holds.
- Duration: How sensitive the bond fund is to interest rate changes. A higher-duration fund is more sensitive to changes in interest rates than a lower-duration one, and if rates rise, a high-duration fund may lose money.
- Credit rating: This is an average of the creditworthiness of all the securities held. Ratings agencies, such as Moodyâs, Standard & Poorâs, and Fitch, assign credit ratings to individual bonds. The safest are rated AAA; the riskiest are D.
- Yield to maturity: The average yield of all the funds.
- Sectors: The types of securities held.
The stated purpose of the bond fund will determine its holdings. For example, a Treasury bond fund that targets the long end of the Treasury yield curve will own U.S. Treasury bonds with maturities of 20 years or longer, while an intermediate corporate bond fund may own securities with seven years or less remaining to maturity.
Bond funds usually make monthly distributions that are payable directly to the fundâs investors. Alternatively, as an investor, you might choose to reinvest distributions into the fundâmuch as stocks and stock funds allow you to reinvest dividends into additional shares.
If you want your money to grow, youâll need to invest.
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The biggest difference between owning a bond fund and buying an individual bond is that an individual bond will mature, at which point you receive your principal back (in addition to the coupon payments along the way). The price will fluctuate inversely to moves in interest rates, but if you hold it until maturity, youâll get the coupon yield plus your principal back.
Because a bond fund includes hundreds or thousands of individual bonds that may be bought, sold, or held until maturity, the fund itself doesnât âmature.â Most funds pay a monthly income (related to the coupons on the bonds it holds), but the fund itself is tied to interest rates.
In a rising interest rate environment, bond funds typically lose money. Learn more about bond market basics.
Bond mutual funds vs. bond ETFs
Bond mutual funds and bond ETFs share the same basic structure; each has a manager (or management team) that invests customer shares in a diversified pool of securities and thus charges a management fee. But there are also important differences. Depending on your objectives (particularly your expected holding period), you might choose one or the other.
That said, if you participate in a company 401(k) plan, your investment options might be limited to a few preselected mutual funds. The good news is that the commission (âsales loadâ) is typically waived.
Here are the key differences between bond mutual funds and bond ETFs:
- Pricing and settlement. At the end of each day, a mutual fund settles to the closing price of all the securities in the fund, tallies up the value, subtracts fees and expenses, and arrives at the net asset value (NAV).
- Liquidity. Mutual funds can only be bought and sold once per day, at the dayâs NAV. ETFs, however, are more like stocksâtheyâre listed on exchanges such as the New York Stock Exchange and change hands throughout the trading day.
- Tax efficiency. ETFs tend to be more tax efficient, as investors are required to pay taxes only on closed positions that realize capital gains. Mutual funds tend to have more turnover, which generates more capital gains. These are passed along to investors throughout the year.
- Transaction costs. If you buy a mutual fund through a broker or bank, youâll likely pay an up-front commission called a âsales load.â With an ETF, your broker sets the rate. In recent years, most retail brokers offer zero-commission trading on ETFs.
- Reporting. ETFs disclose their holdings each day. Mutual funds are only required to disclose holdings and fees quarterly via a filing with the Securities and Exchange Commission (SEC).
In a way, it all comes down to the holding period. If you plan to buy and sell in the short term, the ETF is a better choice because you wonât incur a sales load, and you can see (and trade on) the prevailing price at any point in any trading day. If you plan to hold the fund for years in a tax-advantaged retirement account that has a no-load agreement with the fund company, you might choose a mutual fund, particularly if itâs an actively managed fund with a top-notch professional management team selecting the bonds.
Have you started saving toward retirement? If so, great! But how do you decide what to invest in?
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Bond funds offer many benefits and allow you to easily incorporate diversified fixed-income exposure. But before you jump in, make sure you understand how bond funds work and how they differ from individual investments in bonds and other fixed-income securities. Next, if you have a choice between bond mutual funds and bond ETFs, consider your objectives and time horizon.
Once youâve established these things, youâll need to decide what typeâor typesâof bond funds you would like to invest in. Some invest only in Treasury securities; some focus on corporate bonds, municipal bonds, or bonds from across the globe. Some focus only on short-term maturities; some take a longer view. Educate yourself on the bond fund types, consider the relative risks, and make your choice.
This article was most recently revised and updated by Debbie CarlsonThis article was most recently revised and updated by Doug Ashburn
